Being a collection of thoughts, observations, comments, opinions and views on investing--especially for the long term.
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Tuesday, January 08, 2008

Real Estate and Leverage: How much is best?

Reader's Question: I'm 28 years old. My wife and I both work as electrical engineers in jobs that pay well. Using our savings we have been buying income-producing real estate to replace our employment income and now own 11 units. Is real estate the best vehicle for achieving our goal of becoming financially independent to free up time for activities we consider more meaningful? I have not found other investments that offer such handsome cash yields and permit a similar degree of leverage. Also, regarding leverage, what is the optimal amount of overall leverage for our property portfolio? Is it wise to "lever to the max" with exotic strategies (like wrap notes on properties purchased subject-to), or would we be better off de-leveraging our portfolio so that we don’t need to keep as much cash on hand to cover downside risk associated with leverage? I am struggling with the correct amount of property to purchase given our cash reserves.

In asset allocation and capital structure, the two areas of portfolio management your questions relate to, there are many different investing approaches, each of which has its own merits and unwavering supporters. Rather than try to show in any objective sense that one approach is always superior to the others, I will provide a personal perspective based on my own investing experiences, going broader than your specific inquiry to provide a fuller picture of what has worked for me over the past 25 years. I hope anyone reading this article is able to benefit from what I have to say; however, since even small differences in personal circumstances and preferences can sometimes lead to very different choices and approaches to investing, I encourage you to consider my opinions only as a point of reference, while proceeding to seek out advice from professionals who have the time and expertise to understand your situation thoroughly and work with you more closely to achieve your goals.

Real Estate Investing During the 1980s and 1990s

Since you are targeting a high cash yield and refer to your real estate as "units," I assume that you own apartments (though office buildings, neighborhood retail stores, mixed-use properties, storage facilities, mobile home parks and other real property are also all capable of generating predictable cash flow).

During the early 1980s, I made my first income property investment using a few thousand dollars I had managed to save from my job as a teaching and research assistant while studying for my graduate degree at an East Coast university and living frugally in a shared student house. I invested in apartments in California through a partnership run by an experienced general manager familiar to me through friends and relatives. We were leveraged at about 70% loan-to-value and the property produced good cash flow distributions. With California real estate steadily appreciating, the investment did well throughout the 1980s.

Following graduation in 1985, I took a high-paying job on Wall Street and continued to invest my (now more substantial) savings into other apartment buildings in Southern California. With occupancy above 95%, rents rising at above 5% per year, and limited available land for new development, rental properties continued to appreciate. I recall at the end of 1990 receiving an unsolicited offer for a 16-unit property of ours at a price of $1.15 million (or $72,000 per unit, a very attractive price at that time), which on paper produced a total return-on-equity of 150% in less than three years!

But good times, of course, don't last forever. The U.S. recession beginning in late 1990 hit Southern California hard. Real estate prices softened and buyers evaporated. Realtors and investors caught in the fallout coined the phrase "Stay alive till '95," expressing their confidence that the market would recover by the middle of the decade. Recovery, however, was slower than expected, and significant market strength did not return until around 2000, a full decade following the 1990 peak.

During the market nadir in the mid-1990s, the vacancy rate in one of our buildings rose to 15% and we had to reduce rents by about 10% and offer move-in specials to attract new tenants. In the worst year of operations, cash flow became negative by about 1% of property value (which would have been worse if we had been leveraged more highly).

After what in retrospect was a long roller-coaster ride, partially buffered by not being over-leveraged, we ended up selling the properties, mostly during the market runup from 2000 to 2005. During my total 10- to 15-year holding period, I achieved acceptable but unimpressive, single-digit compounded annnualized returns. This muted, bond-like, long-run performance of an equity investment is largely a reflection of the extended market slump during the mid-1990s, but perhaps the more important outcome from this experience is that we survived and even managed to make a little money during a period when a number of more highly leveraged investors and developers faced foreclosure and bankruptcy.

Lessons from the Last Time Around

With attention to leverage and cash flow, a few observations may be helpful:

Cyclicality: Despite a strong secular tendency to rise indefinitely, real estate markets also exhibit significant cyclical behavior. On a timing clock, with 12 o'clock at the market's top and 6 o'clock at the bottom, I would pair up the following times and dates:

9 o'clock: Market rises in late 1980s12 o'clock: Market peaks at end of 19903 o'clock: Market falls during early 1990s6 o'clock: Market bottoms around 19959 o'clock: Market recovers in late 1990s

Though it may still be too early to judge conclusively, I suspect that we will likely look back at 2005 or 2006 as defining another 12 o'clock real estate market peak.

Leverage and Cash Flow: Leverage slices both ways, producing quick double-digit returns on the way up (as during the middle and late 1980s) and often even quicker negative double-digit returns on the way down (as from 1990 to 1995). As a general principle, I believe it prudent never to leverage a property beyond the zero-cash-flow breakeven point between positive and negative operating cash flow (after debt service and a reserve charge for major repairs, but before depreciation and amortization). A conservative rule of thumb for determining appropriate leverage is to apply a stress test by bumping the economic vacancy rate up to two or three times its normal level (e.g., 5% vacancy becomes 10% to 15% vacancy) and making sure that the property still has either sufficient positive cash flow or adequate cash in the bank to cover this worst-case scenario for a full year of stressed operation.

Total Investment Return: While prudent cash flow management and avoidance of over-leverage (of which a wrap note can be a tell-tale sign) are important for survival during times of protracted rental market weakness, investment returns are often more impacted by property price appreciation than cash flow. Particularly for investment horizons of 10 years or shorter, market timing tends to matter. Admittedly, buy and sell decisions are difficult to get exactly right and each time around is different from the previous times, but I believe that it is possible to cultivate a type of "wisdom" about the markets by observing the macro and local economic forces and their influence on prices over many cycles, thereby developing a slight edge over less diligent players.

Don't Forget About Alternative Markets

Between 2000 and 2005, while I was selling my units in California, I seriously looked for replacement properties in the Washington state area where I now live. My target was a 15% return-on-equity over a pro forma five-year investment horizon, consistent with an 8% cap rate, at 70% loan-to-value, 7% debt service (principal and interest), a 10% cash-on-cash return, and 3% annual property price appreciation, fully accounting for property management fees during the holding period and brokerage fees upon sale. During my property search, I made a handful of offers but was unable to close on a desirable investment property at my price target.

What drove my direct investment target was an investment alternative: indirectly investing in real estate by buying shares of publicly listed REITs. At that time, which was in the wake of the dot-com bubble when office vacancy rates had risen to 20% in high-tech centers, shares of office REITs were trading at depressed price levels consistent with my 8% cap rate and 10% cash-on-cash return target. I viewed office REITs as more attractively priced and having more upside pootential than apartment, retail and other REITs, and proceeded to roll my sales proceeds from the California apartments into shares of Equity Office Properties and Trizec. As good fortune would have it, these two office REITs ended up getting bought out at premium prices in late 2006 and early 2007 by large private-equity buyout funds, providing me with returns that well exceeded my original total return target.

The message here is that, before concluding that direct ownership of income-producing real estate is the best way to meet your investment objectives, I would encourage you to give serious consideration to at least the REIT market and, more generally, the overall stock market. Since the middle of last year, with the subprime crisis feeding recession fears, REITs have taken a fall and are again beginning to look relatively attractive. In my opinion, HRPT Properties (NYSE: HRP), an office REIT with class A and class B properties in both major and more minor cities, is worth considering, since it is now trading at just 65% of book value (equivalent to a "see through" 9% to 10% cap rate with a 14% to 15% cash-on-cash return) and offers an 11% dividend which looks stable. This or other REITs or other dividend-paying stocks may also provide you with the sense of financial independence you are seeking through direct ownership of real estate.

Although I currently own no real estate other than my own residence, I expect again to buy investment properties when an attractive opportunity presents itself. My guess is that the U.S. real estate market as a whole is now at about 3 o'clock on the timing model mentioned above, and could have another year or two to go before reaching the 6 o'clock bottom. The Seattle market where I am is still performing stronger than most other markets, which leads me to believe that I could have even a longer wait if I keep my local focus. On the other hand, I'm sure that there must be a few markets in other states (including your area?) where great deals may be found even this year.

When a Job Can Be More Than Just a Job

Your desire to generate investment income to give you financial freedom to pursue other activities you believe will be more fulfilling than continuing to work at your job as an engineer is a common goal of many people in our 21st-century society dominated by large corporations driven by efficiency and profit objectives. For better or worse, within a few years on the job, most of us Americans come to view our occupations primarily in financial terms, i.e., exchange of our labor for money, while disregarding less tangible benefits such as constructive participation in an endeavor for the good of society, contributing to the smooth operation of our economy, making widgets that we all need and use, helping others by applying our individual talents, etc.

Given the focus of so many Americans on becoming financially independent and retiring early, I was surprised recently to run across an interesting statistic indicating the extent to which America has become less aristocratic over the past century. In 1929, 70% of the income of the top 0.01% (or 1 out of 10,000) earners came from investment income derived from ownership of income-producing assets such as real estate, stock and bonds. By contrast, in 1998, again among the top 0.01% of earners, just 20% of income came from income-producing assets, while the remaining 80% came from wages and entrepreneurial income. (From Piketty and Saez, "Income Inequality in the United States, 1913-1998," as cited in Rajan and Zingales, Saving Capitalism from the Capitalists, 2003, p. 92)

I find it intriguing and even inspiring that the bulk of the income of top earners comes from business endeavors that these top earners are actively involved in as wage earners and entrepreneurs. What this indicates is that today in America, even moreso than a few generations ago, tremendous opportunities exist for anyone clever enough, bright enough and enterprising enough to apply their talents constructively to provide products and services in high demand. In other words, we should view our labor not just as a simple exchange of our time for money but also, at a higher level, as a contribution to the advancement and betterment of society with potential for phenomenally high compensation for the highest achievers. I'm not sure how you are planning to spend your time if or when you do one day leave your current job, but here's a suggestion: how about aspiring to rise to the level of those one-in-ten-thousand hardworking wage earners and entrepreneurs who are making a difference in our world? Generous financial and personal rewards are apparently available for those who succeed.

Certainly, investing to achieve self-sustaining personal lifetime income is a worthy goal to have. But, let's not stop there. Anyone focussed and fortunate enough to get that far should, I feel, both for one's personal satisfaction and for the good of society, actively proceed to find ways to share one's expertise and continue contributing to improving the lives of everyone.

38 Comments:

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REITs ate NOT investments in Real Estate. They are simply pieces of paper. You are investing in company stock whose primary business is to won and manage real estate for healthy fees.Nothing wrong with REITs. But, they are stocks.

We are struggling with a lot of the issues you raised in your response. When I finished my MBA I had to make a choice between 60 hour weeks to make money for money's sake and taking a lower-paying position in the engineering field that I had more experience in combined with starting some companies that I build on my own. Perhaps I have not found the right opportunity yet, but after a few employers it seems that an entrepreneurial spirit is always extinguished by the bureaucracy and mundane tasks of the everyday work week. Our desire to escape this ho-hum culture is what has driven our income replacement focus over the last few years. We have definitely focused on keeping our lower paying jobs for the sake of society, but at times it seems fruitless and naive. I guess time will tell which "camp" we will land in.

Your comments regarding leverage seem spot-on from my experience. I have learned that there is no free lunch if you buy inherently volatile investments. You are unnerved by this volatility which necessitates higher cash reserves (or lines of credit to fund shortfalls at high loan constants) that sap your overall portfolio return. For now I will err on the side of holding more cash and sapping returns...damned risk tolerance! Some accredited investors I have met convinced me that cash gives you staying power and is the key to long-term success.

Thanks for the REIT recommendation. I will definitely take a look at it with that yield ;-)

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Great post. Reading real estate forums all over the web will reveal large numbers of people asking about 100% financing deals. They just haven't run the numbers and understand the risks of overleverage. Your vacancy and expense projections have to be perfect or you will be in a negative cashflow situation. Do you have enough reserves to stand that a year or two or five out?

If you can't afford 20% down, you can't afford to do the deal. If you can afford to put the 20% down, but choose not to - then that is a differenct scenario.

Dear Lloyd, I really enjoy your investment blog. I was reading your "Real Estate and Leverage: How much is best?" piece and found it very interesting. I wanted to pick your brain on a few things I have been grappling with over the the years:

1) I totally agree with you about not leveraging a property beyond the negative operating cash flow (after debt service, reserve charge for repairs, depreciation & amortization). However, I hear conflicting advice from others about real estate. I am pretty cashed up -- I work at a Wall Street firm and never reinvested my yearly bonuses the past 7 yrs. I am getting advice that I should just buy a place and rent it out even though the rental income would not cover all the mortgage payment. I don't think this is a very good idea but I keep hearing that if you can cover about 60-70% of your mortgage, the remaining 30-40% can be written off with depreciation come tax time. Do you agree with this at all or do you unequivocally recommend an investment should always be undertaken if you can at least break even on the mortgage payments?

(2) I grew up in Washington State and am aware that the market has yet to soften like everywhere else in the US. I noticed a ton of condominum projects in the Seattle downtown and Bellevue areas. I was shocked to find how expensive they were and never really thought of Washingtonians wanting to live in a condo. Every real estate broker is telling me that Seattle will be the next New York City (I'm a big seller of this story). I don't like condos because of monthly fees. Do you think there is upside in downtown condos as an investment? What is your view on all the condos being built in the Seattle downtown and Bellevue areas?

(3) What are your thoughts about the Washington, D.C. area? I went to university there. It will always be a renters market because of the nature of the city (i.e. fresh college grads moving there for work and it being a very transient city in general). I'm thinking of investing there, but noticed a lot of supply on the internet. Moreover, the market has gone up probably 150-200% the past 10 years. You think I should be patient and continue to wait? I never thought of D.C. of having high income wage earners, other than lawyers, who would have the ability to buy such high priced property in DC these days. Empirically, the prices in DC don't make sense to me. What is your view?

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